Foreign enterprise equity transfers: a case study

In the previous issue we discussed the legal restrictions on transfers of equity of foreign investment enterprises (FIEs). In this article we examine the issue in the particular context of joint ventures, by looking closely at a specific case.

Details of the case

Songjiang is a Sino-foreign cooperative joint venture. Its legal representative is Mr Wang, the chairman of the board appointed by the foreign shareholder. In 2007, Wang executed an equity transfer agreement with the Chinese shareholder (the transferee) to transfer of all of the foreign party’s equity to the Chinese shareholder. It specified that the transferee would carry out the approval and business registration procedures required for the change in shareholders. However, the transferee failed to do this.

In 2009, a van belonging to Songjiang was involved in a traffic accident, resulting in the death of the injured party. A court found Songjiang and the driver jointly and severally liable, ordering them to compensate the family of the deceased in an amount exceeding RMB390,000. In October 2010, the court issued an order requiring Songjiang to perform the judgment. Thereafter, pursuant to another application, the court took measures to prevent Wang leaving the country. (As the equity transfer had not been carried out, Wang remained the legal representative of Songjiang).

Key issues

In this case, the following three major legal questions need to be considered:

Did Wang have the authority to execute?

Wang executed the equity transfer agreement as the authorized representative of the foreign party, not in his capacity as legal representative, making this a legal and valid act of agency.

Is the equity transfer agreement valid?

Pursuant to FIE laws and the Supreme People’s Court Several Issues Concerning the Trial of Disputes Involving Foreign Investment Enterprises Provisions (1), an agreement to transfer of the equity of an FIE only becomes effective after the approval procedures have been carried out. If approval procedures are not carried out, however, the contract is not necessarily invalid.

As mentioned last month, pursuant to the abovementioned provisions of the Supreme People’s Court, where an equity transfer agreement has not been subject to examination and approval, the party with the obligation to carry out the approval procedures is required to do so.

If it does not, the other party has the right to take legal action, requesting termination of the contract and compensation for its loss; or request that the court order the other party to perform its obligation; or request that the court permit it to carry out the approval procedures itself.

What risks does the foreign party face?

In this case, the foreign shareholder failed to ensure that the transferee carried out of the approval and registration procedures, with the result that the innocent legal representative appointed by it was prevented from leaving the country. In fact, as the foreign shareholder was still legally a shareholder of the company at this time, if the legally specified conditions were satisfied, it could have been required to bear joint and several liability for the debts and liabilities of the company and thus face more serious legal consequences.

Legal procedures

For the above reasons, the foreign shareholder of an FIE should, when transferring its equity or making another change, appoint someone specifically to carry out the following legal procedures.

Approval and registration

In practice, disputes over changes in shareholders regularly arise due to the failure by one of the parties to carry out the required approval procedures. Foreign investors should take note of this. In the above case, the conversion of Songjiang from a Sino-foreign cooperative joint venture into a wholly Chinese-owned enterprise not only involved approval and registration procedures, but also required, the return of the approval certificate of the FIE to the approval authority for cancellation within 30 days of approval of the change in equity, in accordance with the Changes in the Equity of Investors of Foreign-Invested Enterprises Several Provisions.

Personnel matters

The PRC Employment Contract Law, implemented in 2008, and the PRC Social Insurance Law, which will come into force on 1 July, increase the protection of workers’ interests and the constraints on employers. An FIE that restructures can avoid unnecessary loss by handling its employment relations correctly.

Article 33 of the Employment Contract Law specifies that “a change in the name, legal representative, main person in charge or investor of an employer shall not affect the performance of an employment contract”. Accordingly, in the above case, although the foreign party transferred all of its equity to the Chinese party, this did not affect the validity of the employment relationships between the company and its workers. However, in the following circumstances, the foreign and Chinese parties are required to make arrangements and add provisions relating to the resettlement of employees to the equity transfer agreement:

(1) where the transferee, for management reasons, plans to execute new employment contracts with the employees;

(2) where the Chinese party transfers equity to the foreign party and this transfer involves the transfer of state-owned property rights; or

(3) where a large or medium-sized state-owned enterprise undergoes a reorganization, converting it into an equity or cooperative joint venture.

If a reorganization converts an enterprise into an equity or cooperative joint venture, the new enterprise additionally needs lawfully to handle the employment relationships between the former enterprise and its employees in accordance with the Reassignment and Resettlement of Redundant Personnel in Connection with the Separation of the Main and Secondary Business, and Restructuring of the Secondary Business, of Large and Medium-Sized State-Owned Enterprises Implementing Measures.

Other aspects

An FIE that changes its equity must also amend its tax, bank and foreign exchange registrations, in addition to the approval procedures for the amendment of its business registration.